Suppose we have two equally risky firms, Firm A and B. Firm B’s shares are curre

Question

Suppose we have two equally risky firms, Firm A and B. Firm B’s shares are currently worth $100, and they are expected to be worth $120 in one year. Personal dividend tax rate is 30%, and capital gains are exempt from taxes. (10 marks)

a. What is the after-tax return on Firm B?

b. If Firm A opts to pay a dividend of $20 per share in one year, what is the after-tax return on Firm A?

c. Given that dividends will reduce firm value proportionally, what is the share price of Firm A’s stock if it pays a dividend of $20 in one year?

Explanation / Answer

a. If Firm B sells the shares in second year then,

Capital gains would be = $120 - $100 = $20

Since, capital gains are exempted from taxes, the  after-tax return on Firm B would be $20.

b.  The after-tax return on Firm A = Dividend - personal dividend tax

= $20 - 30%

= $14 per share

c. It is said that the dividends will reduce firm value proportionally that is dividend paid are equal to the price of the share i.e $20.

The share price of Firm A’s stock = $20 as it would not change if dividend is paid.

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